Finances

What are Tax Credits and how can you use them?

Taxes are a fact of life, and whatever your thoughts on them, they fund our governments and social services. Tax credits are a method of easing the tax burden on particular groups of individuals, based on circumstances.

Different countries offer a range of tax credits, and Germany is no different. This article is designed to help you understand the tax credits available to you in Germany and how to claim them. There is a difference between tax credits and tax deductions, which is essential to understand, and we discuss this later on in the article.

Tax is complicated!

One thing we can probably all agree on is that most tax systems are very complicated. Taxing a person’s income has been commonplace for centuries, and each new government has added more ways to levy tax. So on top of income tax, there is vat, social insurance, and property tax for individuals. Once you start looking at business taxation, the rules are even more complicated.

If you have a separate business income from your salary, it makes sense to keep the two segregated. Using a Penta Business Account, all your business income and expenses can be held separately, with the added benefit of automated accounting. When it comes to submitting your tax declaration, this simple step could save you hours of sorting through invoices and receipts.

Before going any further, it is worth considering your income and tax position. If you are an employee, with no other income, then your tax situation is very straightforward. Income tax is taken at source from your salary, along with social payments and additional charges. In Germany, employees can easily apply to the tax office for tax refunds, and reductions you can apply for are well documented. There are also cheap ways of getting help with your taxes, including inexpensive online tax declaration software.

Where a personal tax situation gets complicated is if they have a second income or perhaps work under one of the freelance regimes, such as sole-trader or a partnership. In that instance, the company taxation rules can come into play, adding a whole extra layer of tax credit and tax deduction complication.

What are Tax Credits

A tax credit is a sum that is deducted from the tax that you owe after you have calculated your yearly tax obligations. In comparison, deductions are used to reduce your taxable income and are therefore not as beneficial as tax credits.

So as an example, say you have a taxable income of €20,000, and an income tax of €1600 to pay. (These are not accurate figures, just examples for illustration purposes). 

A tax credit of €500 will reduce your tax liability to €1600 – €500 = €1100.

A tax deduction of €500, on the other hand, will reduce your taxable income to €19,500 (€20,000 – €500), and so leave your tax liability at €1520.

So a tax credit saves you €420 more than the equivalent tax deduction.

Governments use tax credits in various ways to target specific people or promote particular behavior because they are so favorable when compared to deductions. 

We will cover tax deductions in a separate article in the future. Just keep an eye on our blog for updates.

Tax Credits Available

Managing your tax credits is probably a job best left to a tax specialist. Because they are specific incentives that can give a significant reduction in your tax liability, the rules can be complicated.

Double Taxation Credit

In most countries now, you are required to declare your worldwide income when submitting a tax return. This means that if you happen to have a property in another country and earn rental income from it, you should declare that income in Germany. But declaring the income in Germany will make you liable for tax on the income, even though you may have already paid tax in the country where the property is located. 

Double taxation agreements exist between many countries the world over, and Germany is no exception. The double taxation agreement is a tax credit that allows you to deduct the amount of tax paid in another country from the tax liable in Germany.

Municipal Tax Credit

Corporate tax in Germany is one of the highest in Europe, at around 30% in total. But it is made up of a federal tax of 15% and a municipality tax which is set locally. The calculation of the municipal tax credit is definitely one that should be put in the hands of your accountant or financial advisor. 

The amount of credit depends on the percentage of income you receive from salary compared to the revenue from your business activities. 

For example, say you earn 60% of your taxable income from employment and 40% from a business activity, and your income tax liability is €20,000. You can receive a business tax credit of up to €8,000, which is 40% of your tax liability. This tax credit can be used against your income tax liability.

R&D Tax Credit

From 2020, a new tax credit for corporations has come into force, allowing companies to claim for research and development costs. There is a cap of €500,000 on this tax credit. A company can claim 25% of the total spent on salaries for the R&D staff.

Take Financial Advice

As we mentioned at the beginning of the article, taxation, and mainly corporate taxation, is a minefield of complication! If you get it wrong, the fines can be much more than the cost of an accountant. Our advice is to consult a tax specialist if your income is anything more than just a salary that is taxed at source.

Part of simplifying your tax arrangements is to keep your personal and business income separate. Opening a Penta Business Account today can really help. And you get automated accounting as well, with business expenses separated into categories! Perfect for keeping track of what your business is spending and on what.